How bear markets wreak havoc on succession plans

When the equity markets decline, as they have this year, they take the value of your firm down with them.

Sure, if you're creating a succession plan right now, or a sale is imminent, you may still be able to tout your numbers from the end of 2021. But that window is closing fast; it's more than likely your current run rate is what buyers will assess when calculating the worth of your firm.

But just how damaging is a bear market? Is an extended drop in AUM a dollar-for-dollar decline that parallels your firm’s value?

Not even close.

Let’s say you have $400 million under management with an average fee of 90 basis points. That’s $3.6 million in revenue. Now let’s assume you operate at a 35% profit margin. That means the business has expenses of 65%, or $2.34 million, resulting in a net profit of $1.26 million.

As an example, let’s assume your firm has 50% of its assets in equities and the market falls 30%. All things being equal, that would equate to a 15% decline in your AUM. So rather than managing $400 million, you're now managing $340 million.

Ninety bps billed on $340 million would bring in $3.06 million. But your expenses haven't decreased. In fact, given inflation and the extra work that’s required to guide clients through a bear market, your costs could very well increase.

But for the sake of this discussion, let’s assume that your expenses remain the same.

Your net profit drops 43%, from $1.26 million to $720,000. To sum that up, a 30% decline in equities could result in a 43% decline in profits.

Given that all transactions are based on some sort of discounted cash flow model, regardless of whether the headline number is calculated upon EBITDA, EBOC or a multiple of revenue, it’s still ugly.

Granted, each firm is unique and not every firm would see the same drop. But the basic framework is consistent almost no matter how your business is structured.

If you’ve been keeping abreast of trends, you could argue that it’s such a strong seller's market that it won’t have a material impact on your firm’s value. This might hold true in the short run. Buyers can, and will, play with assumptions to feel good about their decisions. But as time goes by, and one quarter becomes two quarters, and then three, even your earnings from the not-so-distant past become irrelevant. Any buyer will know to focus on your current run rate.

If you're more than five years away from any sort of succession plan, a prolonged bear market may not impact you much. But if you plan on doing something within the next couple of years, you might want to consider moving quickly. After all, if a client has most of their wealth in their employer’s stock and is planning on retiring in two years, you wouldn’t advise them to wait to diversify.

Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with $15 billion in AUM.